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Endogenous Borrowing Constraints and Consumption Volatility in a Small Open Economy

  • Carlos de Resende

Consumption volatility relative to output volatility is consistently higher in emerging economies than in developed economies. One natural explanation is that emerging economies are more likely to face borrowing constraints and, as a consequence, find it more difficult to use international capital markets to smooth consumption. The author investigates how much this mechanism alone can account for the relative consumption volatility differential between emerging and developed economies. His theoretical approach relies on a standard dynamic general-equilibrium model of a small open endowment economy that is subject to an endogenous borrowing constraint. The borrowing constraint makes the small economy exactly indifferent between two options: (i) repaying its external debt, or (ii) defaulting and having to live in financial autarky in the future. The model for the constrained economy is calibrated to match Brazilian data during the period 1980-2001. The author's findings suggest that the model is capable of accounting for more than half of the observed relative consumption volatility differential.

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Paper provided by Bank of Canada in its series Staff Working Papers with number 06-37.

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Length: 41 pages
Date of creation: 2006
Date of revision:
Handle: RePEc:bca:bocawp:06-37
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  1. Grossman, Herschel I. & Han, Taejoon, 1999. "Sovereign debt and consumption smoothing," Journal of Monetary Economics, Elsevier, vol. 44(1), pages 149-158, August.
  2. Cole, Harold L & Dow, James & English, William B, 1995. "Default, Settlement, and Signalling: Lending Resumption in a Reputational Model of Sovereign Debt," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(2), pages 365-85, May.
  3. Jeremy I. Bulow & Kenneth Rogoff, 1988. "Sovereign Debt: Is To Forgive To Forget?," NBER Working Papers 2623, National Bureau of Economic Research, Inc.
  4. Cole, Harold L. & Kehoe, Patrick J., 1995. "The role of institutions in reputation models of sovereign debt," Journal of Monetary Economics, Elsevier, vol. 35(1), pages 45-64, February.
  5. Aiyagari, S. Rao & Gertler, Mark, 1990. "Asset Returns With Transactions Costs And Uninsured Individual Risk: A Stage Iii Exercise," Working Papers 90-43, C.V. Starr Center for Applied Economics, New York University.
  6. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates and the current account," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  7. S Rao Aiyagari & Mark Gertler, 1997. "Asset Returns with transaction costs and uninsured individual risk," Levine's Working Paper Archive 648, David K. Levine.
  8. Reinhart, Carmen & Calvo, Guillermo, 2000. "When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options," MPRA Paper 6982, University Library of Munich, Germany.
  9. Reinhart, Carmen & Calvo, Guillermo & Leiderman, Leonardo, 1992. "Capital Inflows and Real Exchange Rate Appreciation in Latin America," MPRA Paper 13843, University Library of Munich, Germany.
  10. Calvo, Guillermo A. & Vegh, Carlos A., 1999. "Inflation stabilization and bop crises in developing countries," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 24, pages 1531-1614 Elsevier.
  11. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, vol. 78(3), pages 402-17, June.
  12. Cristina Arellano, 2005. "Default Risk, the Real Exchange Rate and Income Fluctuations in Emerging Economies," 2005 Meeting Papers 516, Society for Economic Dynamics.
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